Capacity utilization
Encyclopedia
Capacity utilization is a concept in economics
and managerial accounting which refers to the extent to which an enterprise or a nation actually uses its installed productive capacity. Thus, it refers to the relationship between actual output
that 'is' produced with the installed equipment and the potential output
which 'could' be produced with it, if capacity was fully used.
It is believed that when utilization rises above somewhere between 82% and 85%, price inflation will increase. Excess capacity means that insufficient demand exists to warrant expansion of output.
All else constant, the lower capacity utilization falls (relative to the trend capacity utilization rate), the better the bond market
likes it. Bondholders view strong capacity utilization (above the trend rate) as a leading indicator of higher inflation
. Higher inflation—or the expectation of higher inflation—decreases bond prices, producing a higher yield to compensate for the higher expected rate of inflation.
Implicitly, the capacity utilization rate is also an indicator of how efficiently the factors of production
are being used. Much statistical and anecdotal evidence shows that many industries in the developed capitalist economies suffer from chronic excess capacity. Critics of market capitalism
, therefore, argue the system is not as efficient as it may seem, since at least 1/5 more output could be produced and sold, if buying power was better distributed. However, a level of utilization somewhat below the maximum prevails, regardless of economic conditions.
, capacity utilization is normally surveyed for goods-producing industries at plant level. The results are presented as an average percentage rate by industry and economy-wide, where 100% denotes full capacity. This rate is also sometimes called the "operating rate". If the operating rate is high, this is called "overcapacity", while if the operating rate is low, a situation of "excess capacity" or "surplus capacity" exists. The observed rates are often turned into indices.
There has been some debate among economists about the validity of statistical measures of capacity utilization, because much depends on the survey questions asked and on the valuation principles used to measure output. Also, the efficiency of production may change over time, due to new technologies.
For example, Michael Perelman
has argued in his 1989 book Keynes, Investment Theory and the Economic Slowdown: The Role of Replacement Investment and q-Ratios that the US Federal Reserve Board measure is just not very revealing. Prior to the early 1980s, he argues, American business carried a great deal of extra capacity. Running close to 80% indicated at the time approaching capacity restraints. Since that time, firms have scrapped much of their most inefficient capacity. As a result, a modern 77% capacity utilization now would be equivalent to a historical level of 70%.
However, as output increases and well before the absolute physical limit of production is reached, most firms might well experience an increase in the average cost of production—even if there is no change in the level of plant & equipment used. For example, higher average costs can arise, because of the need to operate extra shifts, to undertake additional plant maintenance, and so on.
%OG = [(AO – PO)/PO] x 100%
By contrast, the Institute of Supply Management (ISM) index asks respondents to measure their current output relative to "normal capacity", and this yields a utilization rate, which is between 4 and 10 percentage points higher than the FRB measure. Again, the time series show more or less the same historical movement.
See: http://www.federalreserve.gov/releases/g17/current/ Board of Governors of the Federal Reserve System: Industrial Production and Capacity Utilization
The average utilization rate of installed productive capacity in industry, in some major areas of the world, was estimated in 2003/2004 to be as follows (rounded figures):
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
and managerial accounting which refers to the extent to which an enterprise or a nation actually uses its installed productive capacity. Thus, it refers to the relationship between actual output
Output
Output is the term denoting either an exit or changes which exit a system and which activate/modify a process. It is an abstract concept, used in the modeling, system design and system exploitation.-In control theory:...
that 'is' produced with the installed equipment and the potential output
Gross Output
Gross output is an economic concept used in national accounts such as the United Nations System of National Accounts and the US National Income and Product Accounts...
which 'could' be produced with it, if capacity was fully used.
Economic significance
If market demand grows, capacity utilization will rise. If demand weakens, capacity utilization will slacken. Economists and bankers often watch capacity utilization indicators for signs of inflation pressures.It is believed that when utilization rises above somewhere between 82% and 85%, price inflation will increase. Excess capacity means that insufficient demand exists to warrant expansion of output.
All else constant, the lower capacity utilization falls (relative to the trend capacity utilization rate), the better the bond market
Bond market
The bond market is a financial market where participants can issue new debt, known as the primary market, or buy and sell debt securities, known as the Secondary market, usually in the form of bonds. The primary goal of the bond market is to provide a mechanism for long term funding of public and...
likes it. Bondholders view strong capacity utilization (above the trend rate) as a leading indicator of higher inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
. Higher inflation—or the expectation of higher inflation—decreases bond prices, producing a higher yield to compensate for the higher expected rate of inflation.
Implicitly, the capacity utilization rate is also an indicator of how efficiently the factors of production
Factors of production
In economics, factors of production means inputs and finished goods means output. Input determines the quantity of output i.e. output depends upon input. Input is the starting point and output is the end point of production process and such input-output relationship is called a production function...
are being used. Much statistical and anecdotal evidence shows that many industries in the developed capitalist economies suffer from chronic excess capacity. Critics of market capitalism
Capitalism
Capitalism is an economic system that became dominant in the Western world following the demise of feudalism. There is no consensus on the precise definition nor on how the term should be used as a historical category...
, therefore, argue the system is not as efficient as it may seem, since at least 1/5 more output could be produced and sold, if buying power was better distributed. However, a level of utilization somewhat below the maximum prevails, regardless of economic conditions.
Measurement
In economic statisticsEconomic statistics
Economic statistics is a topic in applied statistics that concerns the collection, processing, compilation, dissemination, and analysis of economic data. It is also common to call the data themselves 'economic statistics', but for this usage see economic data. The data of concern to economic ...
, capacity utilization is normally surveyed for goods-producing industries at plant level. The results are presented as an average percentage rate by industry and economy-wide, where 100% denotes full capacity. This rate is also sometimes called the "operating rate". If the operating rate is high, this is called "overcapacity", while if the operating rate is low, a situation of "excess capacity" or "surplus capacity" exists. The observed rates are often turned into indices.
There has been some debate among economists about the validity of statistical measures of capacity utilization, because much depends on the survey questions asked and on the valuation principles used to measure output. Also, the efficiency of production may change over time, due to new technologies.
For example, Michael Perelman
Michael Perelman
Michael Perelman is an American economist and economic historian, currently professor of economics at California State University, Chico. Perelman has written 19 books, including Railroading Economics, Manufacturing Discontent, The Perverse Economy, and The Invention of Capitalism.-Biography:A...
has argued in his 1989 book Keynes, Investment Theory and the Economic Slowdown: The Role of Replacement Investment and q-Ratios that the US Federal Reserve Board measure is just not very revealing. Prior to the early 1980s, he argues, American business carried a great deal of extra capacity. Running close to 80% indicated at the time approaching capacity restraints. Since that time, firms have scrapped much of their most inefficient capacity. As a result, a modern 77% capacity utilization now would be equivalent to a historical level of 70%.
Engineering and economic measures
One of the most used definitions of the "capacity utilization rate" is the ratio of actual output to the potential output. But potential output can be defined in at least two different ways.Engineering definition
One is the "engineering" or "technical" definition, according to which potential output represents the maximum amount of output that can be produced in the short-run with the existent stock of capital. Thus, a standard definition of capacity utilization is the (weighted) average of the ratios between the actual output of firms to the maximum that could be produced per unit of time, with existing plant and equipment (see Johanson 1968). Obviously, "output" could be measured in physical units or in market values, but normally it is measured in market values.However, as output increases and well before the absolute physical limit of production is reached, most firms might well experience an increase in the average cost of production—even if there is no change in the level of plant & equipment used. For example, higher average costs can arise, because of the need to operate extra shifts, to undertake additional plant maintenance, and so on.
Economic definition
An alternative approach, sometimes called the "economic" utilization rate, is, therefore, to measure the ratio of actual output to the level of output beyond which the average cost of production begins to rise. In this case, surveyed firms are asked by how much it would be practicable for them to raise production from existing plant and equipment, without raising unit costs (see Berndt & Morrison 1981). Typically, this measure will yield a rate around 10 percentage points lower than the "engineering" measure, but time series show the same movement over time.Output gap percentage formula
As a derivative indicator, the "output gap percentage" (%OG) can be measured as actual output (AO) less potential output (PO) divided by potential output and multiplied by 100%.%OG = [(AO – PO)/PO] x 100%
FRB and ISM utilization indexes
In the survey of plant capacity used by the US Federal Reserve Board for the FRB capacity utilization index, firms are asked about "the maximum level of production that this establishment could reasonably expect to attain under normal and realistic operating conditions, fully utilizing the machinery and equipment in place."By contrast, the Institute of Supply Management (ISM) index asks respondents to measure their current output relative to "normal capacity", and this yields a utilization rate, which is between 4 and 10 percentage points higher than the FRB measure. Again, the time series show more or less the same historical movement.
See: http://www.federalreserve.gov/releases/g17/current/ Board of Governors of the Federal Reserve System: Industrial Production and Capacity Utilization
Data
The average economy-wide capacity utilization rate in the US since 1967 was about 81.6%, according to the Federal Reserve measure. The figure for Europe is not much different, for Japan being only slightly higher.The average utilization rate of installed productive capacity in industry, in some major areas of the world, was estimated in 2003/2004 to be as follows (rounded figures):
Average utilization rate
- United States 79.7% (April 2008 — Federal Reserve measure)
- Japan 83–86% (Bank of Japan)
- European Union 82% (Bank of Spain estimate)
- Australia 81% (National Bank estimate)
- Brazil 60–80% (various sources)
- India 70% (Hindu business line)
- China perhaps 60% (various sources)
- Turkey 79.8% (September 2008 — Turkish Statistical InstituteTurkish Statistical InstituteTurkish Statistical Institute is the Turkish government agency commissioned with producing official statistics on Turkey, its population, resources, economy, society, and culture. It was founded in 1926 and has its headquarters in Ankara....
) - Canada 87% (Statistics Canada)
